Is Your Portfolio Protected Against Inflation?
Like all hazards in investing, the risk of inflation is always lurking—even when it doesn’t materialize. And because of this ever-present threat, Truepoint portfolios are explicitly built with inflation in mind.
We’ve done the homework, searching for the best inflation hedge across nearly every investable asset class. Here’s what our research shows: It’s not gold, commodities like oil or steel, or TIPS, which only protect against unexpected inflation (consensus expectations factor into the price of TIPS).
Beating Inflation Over Time
We believe the best long-term hedge against inflation is stocks. Specifically, a globally diversified portfolio of stocks.
Since 1926, the S&P 500 has appreciated at an average annual rate of 10.4%, while inflation has advanced at an average annual rate of 3.2%¹. The reason for this is simple—historically, companies have been able to grow earnings and pay dividends at a rate faster than inflation. Large public companies are nimble and have enough pricing power to pass along most of the cost of inflation to consumers2. This dynamic is not ideal for consumers, but it’s great for companies and investors.
But what about the short-term risk of inflation? We know that stocks can get dinged in the short run as inflationary pressures rise. We saw this in the 1970s when the highest inflationary period over the last 50 years coincided with some of the lowest stock market returns. Though less drastic and much shorter-lived, we saw a similar pattern in 2022.
Fighting the More Immediate Threat
One of the best short-term hedges against inflation is short-term bonds.
“Tall Paul” Volcker, Fed Chair who crushed inflation and set the stage for two decades of economic growth, taught us that the most effective tool against inflation is stricter monetary policy. The Federal Reserve board led by Volcker raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. Since then, the Fed has typically followed the Volcker playbook when faced with inflation-raising interest rates to rein it in. When rates rise, long-term bonds get crushed. Short-term bonds quickly mature, generating new cash to deploy into our choice of 1) more bonds, yielding the new, higher interest rates or 2) stocks, if the rise in inflation and interest rates has caused a temporary decline in stock prices.
The purpose of bonds in the portfolio is to provide stability. Because longer-term bonds expose investors to greater interest rate risk and volatility, we consistently maintain a shorter duration than the aggregate bond market. We will, however, adjust our bond duration to capitalize on the opportunities given in any market environment. When the yield curve is sharply upward sloping, we’ll extend duration a bit to capture the higher yields further along the curve. When it is flat or inverted, the excess risk by extending duration isn’t accompanied by excess expected return. In those environments, we’ll decrease duration.
Plan, Don’t Predict
Our bond strategy is consistent with our stock strategy. Neither depends in any way on our ability to predict the future. We think changes in interest rates are just as unknowable as short-term stock market fluctuations. Instead of attempting to predict, we capitalize on opportunities given. Within stocks, that means rebalancing, systematically selling high and buying low, or tax loss harvesting. Within bonds, that means adapting as the interest rate environment adjusts.
Translation: regardless of how much inflation we see, how long it persists, or how stocks react, the Truepoint portfolio is well-positioned to take advantage of the opportunities that arise.
1http://www.econ.yale.edu/~shiller/data.htm
2 The decade with the highest earnings growth for S&P 500 companies is, surprisingly enough, the 1970s. Inflation was suffocating the economy and the stock market was not exactly thriving, but companies were able to pass along higher costs and post record profits. http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/spearn.htm
